Finance for IT Decision Makers

A practical handbook

Michael Blackstaff

• Publisher: BCS, The Chartered Institute for IT
• Year: 2012
• ISBN:
  9781780171241
• Edition: 3
• Topic: Business
• Subtopic: Finance
• Index: Business

Finance is as fundamental to the IT world as it is to most other aspects of life. However, many IT professionals lack knowledge of the particular financial principles on which decisions about IT should be based. Assuming no prior knowledge, this new edition covers all relevant aspects of finance and is updated with International Financial Reporting Standards (IFRS) terminology. It is ideal for all IT decision makers who wish to conquer their fear of finance or refresh existing knowledge.

1 FINANCE AND ACCOUNTS: THE BASICS

The purpose of this chapter is to provide a brief summary of the fundamentals of finance and accounting, and to introduce their terminology sufficiently to enable people with no previous knowledge of the subject to understand the rest of the book. For this chapter a ‘minimalist’ approach in note form has been adopted in order to focus on the fundamentals in the minimum of space. Readers who are familiar with these fundamentals, but who may be less familiar with the terminology of international accounting standards, may find it useful to skim this chapter.

OBJECTIVES

When you have studied this chapter you should be able to:

• explain the main purpose of business, and why the concept of ‘limited liability’ has been vital to its development;
• state the three main sources of company finance;
• explain what a statement of financial position (balance sheet) is;
• show how some typical business transactions affect the statement of financial position;
• explain what an income statement (profit and loss account) is and how it is set out;
• explain what a statement of cash flows (cash flow statement) is and how it is set out;
• explain the difference between cash flow and profit;
• explain what a cash flow forecast is and why it is important.

The principles explained in this book evolved to facilitate business, and it is business that will provide the context for the explanations. However, any organisation can and should be run in a business-like way. Therefore it should not be surprising that the same principles are equally applicable to non-business organisations – government, academia, charities, associations and clubs – although with differences of detail.

As stated in the Preface, this is intended as an international book. It therefore uses the terminology of International Financial Reporting Standards (IFRSs). Table P.1 in the Preface shows every IFRS term used in the book together with the equivalent term used in previous editions. To further assist readers, the first time that an IFRS term appears in the text the previously used term is given in brackets, as in the third, fifth and sixth bullets above. The same is done in the Glossary at the end of the book.

THE PURPOSE OF BUSINESS

The main purpose of a business is to create wealth for the owner or owners. It is helpful to think of a business, even a one-person business, as a separate entity from its owners. In the case of companies this principle is enshrined in law. A company is a separate legal entity. Its owners are called shareholders.

A business may be run by an individual (a ‘sole trader’), by a group of individuals working together (a ‘partnership’) or by a limited company.

Sole traders and partners, except those in a ‘limited liability partnership’ where such are permitted, are liable for all the debts of a business. If necessary, all their personal assets can be required to pay those debts.

Where they are permitted, limited liability partnerships are halfway between traditional partnerships and companies, combining the flexibility of the former with the protection of limited liability associated with the latter.

COMPANIES OR CORPORATIONS

The main purpose of a company or corporation is to limit the liability of the owners (‘shareholders’) to the money that they have invested in it; they may lose that, but nothing else.

Shareholders invest money in a company in return for ‘shares’; the shareholders exercise control and are entitled to profits in proportion to the number of their shares.

The shareholders appoint ‘directors’ (who may also be shareholders) to run the business on their behalf and to report back to them the results and ‘accounts’ at least once a year.

The shareholders also appoint ‘auditors’ to tell them whether the accounts give a true and fair view of the state of affairs of the company and its ‘profit’.

Profit means the ‘revenue’ (income) earned by a business, less the expenses incurred in earning it.

Profit belongs ultimately to the shareholders, but usually only a part is paid to them each year as a ‘dividend’. The rest is retained in the business to finance expansion.

It is not compulsory to pay a dividend. The directors recommend how much, if any, they think the company can afford.

Most companies are ‘private’ companies’, many of which are family businesses.

‘Public’ companies are those authorised to offer their shares to members of the public. They are subject to more stringent regulations than private companies. Only the shares of public companies may be ‘listed’ on a stock exchange.

Other advantages of companies over unincorporated businesses include: additional money may more easily be raised, in exchange for more shares; shares can be bought and sold; there may be tax advantages.

Where companies obtain money

Finance means the management (the raising, custody and spending) of money.

There are three main sources of long-term finance for a company: money invested by shareholders, called ‘share capital’; borrowings (money borrowed from banks or other lenders); and profit retained in the business (called ‘retained profit’).

The profit left after paying all expenses, including interest and tax, belongs to the shareholders. Share capital and retained earnings together are known as ‘equity’.

A company is thus obligated to others for all its money: to its shareholders for its equity (its share capital and retained earnings); to its lenders for borrowings.

Borrowings must usually be repaid by a fixed date. Those repayable more than one year in the future are described as ‘non-current liabilities’; those repayable in one year or less are ‘current liabilities’.

In the course of trading, a company will incur other current liabilities as well, for example ‘trade payables’ (trade creditors) – suppliers from whom it has bought on credit.

Eventually, although perhaps far into the future, when the company is liquidated or ‘wound up’, anything left after all debts have been paid will be repaid to the then shareholders.

Meanwhile, the total of the long-term money used by a company (share capital plus long-term borrowings) is sometimes called its ‘capital employed’.

Liabilities, whether short- or long-term, are obligations that a business owes.

What companies do with money

Some businesses, for example small consultancies, need very little money in order to get started and to remain in business. All they need is people and perhaps a rented office.

Others, for example car manufacturers, need a great deal of money. They have to acquire buildings and manufacturing plant. They also have to stock up with inventories (stocks) of parts and components. All these things are called ‘assets’.

Most businesses fall somewhere in between these extremes.

Assets, like liabilities, may be short-term (current) or long-term (non-current). Here, too, ‘non-current’ means more than one year.

Most non-current assets are used up over time, as is therefore the money used to acquire them. IT equipment and motor vehicles are examples. To replace them requires more money. Not all non-current assets are used up, however. Land is an example.

Accounts often, but not necessarily, record the using up, or ‘depreciation’, of non-current assets on a ‘straight line’ basis (as though it happened by equal amounts each year). However, other methods are permitted.

Assets do not have to be bought. Many of them, including IT assets, can be leased. Instead of a single initial cash outlay, regular payments are made during the life of the asset. Thus, leasing is a way of conserving cash.

Short-term assets are called ‘current assets’. ‘Inventories’ (stocks) are current assets; so are ‘trade receivables’ (trade debtors), which are amounts due from customers to whom goods or services have been sold on credit. Cash is also a current asset.

Current assets are used up or ‘turned over’, usually over short periods of less than a year. Unlike non-current assets, they are continually replenished out of the revenue from sales.

‘Fixed capital’ is a term often used to describe that part of a company’s money (‘capital’) invested in non-current (long-term) assets.

‘Working capital’ is a term often used to describe that part of a company’s capital invested in net current assets (current assets less current liabilities).

‘Goodwill’ is an intangible asset that may arise when one business buys another. It is the amount by which the price paid for the business exceeds the values of the assets less liabilities acquired. It is the amount that the buyer is willing to pay for the good name or the ‘know-how’ of the business.

Assets, whether short- or long-term, are things that a business owns.

HOW A BUSINESS WORKS

How a business works financially is best understood by working through an example. This we shall be doing for the remainder of this chapter, considering one by one, in Example 1.1, a series of common business transactions: seeing how they are recorded and their financial effect.

To do this, we shall use as an example a small manufacturing company just starting up. Imagine that you are the only shareholder.

Getting started

You have started the company by opening a bank account for it and paying in CU100k of your own money in exchange for CU100k worth of shares. Every transaction has two sides. For example, you sell, I buy; I lend, you borrow. Acco...